Q4 2017 Earnings Call Transcript

Published: 22 Feb 2018

[Operator:]

Welcome to the SWM’s Fourth Quarter and Full-Year 2017 Earnings Conference Call. Hosting the call today from SWM is Dr. Jeff Kramer, Chief Executive Officer. He is joined by Allison Aden, Co-Chief Financial Officer; Andy Wamser, Co-Chief Financial Officer; and Mark Chekanow, Director of Investors Relations. Today’s call is being recorded and will be available for replay later this afternoon. At this time, all participants have been placed in a listen-only mode and the floor will be opened for your questions following the presentation. [Operator Instructions] It is now my pleasure to turn the floor over to Mr. Chekanow. Sir, you may begin.

[Mark Chekanow:]

Thank you, Kim. Good morning. I'm Mark Chekanow, Director of Investor Relations at SWM. Thank you for joining us to discuss SWM’s fourth quarter and full-year 2017 earnings results. Before we begin, I’d like to remind you that the comments included in today’s conference call include forward-looking statements. Actual results may differ materially from the results suggested by these comments for a number of reasons, which are discussed in more detail in our Securities and Exchange Commission filings, including our Quarterly Reports on Form 10-Q and our Annual Report on Form 10-K. Some financial measures discussed during this call are non-GAAP financial measures. Reconciliations of these measures to the closest GAAP measures are included in the appendix of this presentation and the earnings release. Unless stated otherwise, financial and operational metric comparisons are to the prior year period and relates to continuing operations. This presentation and the earnings release are available on the Investor Relations section of our website, www.swmintl.com. I’ll now turn the call over to Jeff.

[Dr. Jeff Kramer:]

Thank you, Mark, and good morning everyone. Yesterday, we reported our fourth quarter and full-year results with full-year adjusted EPS of $3.18 exceeding our guidance of $3.15. Before we go into further detail about the quarter and the year, it is important to note that we have a net one-time non-cash tax expense of $39.6 million or $1.29 per share related to the recently enacted U.S. tax legislation. This had a substantial impact on our full-year GAAP financials including the fourth quarter GAAP loss per share. Allison, will provide more color on taxes later in the call. Regarding our overall results for the year, AMS organic sales growth and the benefits from the Conwed acquisition offset the challenges in our recon business we had assumed when we originally issued our guidance. Specific to the fourth quarter, adjusted EPS was $0.64 per share down from $0.80 in part due to lower organic sales in AMS as customers adjusted year-end inventories following several quarters of strong growth. Concurrently, EP faced a difficult comparison to the prior year's fourth quarter. 2017 free cash flow finished at $90 million, a reduction from the earlier expectation of close to 100 million, as we chose to build additional inventory to ensure consistent service levels during our facility consolidation and expansion projects. We expect free cash flow to rebound to more than 100 million in 2018. Shifting to AMS segment results. Excluding the Conwed acquisition, organic sales declined 2% in the fourth quarter but were up 4% for the year. We call transportation sales increased rapidly midyear as we expanded our agent distribution channels for surface protection films. While we saw these customers reduce the year-end inventories during the fourth quarter, we have seen since a more normal order pattern resumed in 2018. Although, fourth quarter transportation sales decline for the full-year, they grew more than 10%. In filtration, we saw a good quarter growth across most product lines while the full-year still finished with the modest decline. We expect filtration sales growth in 2018. In medical, we continue to see gains during the fourth quarter and for the year medical sales finished up in the 2% to 3% range. Industrial sales were up slightly and across the year up 2% to 3% with particular strength in our small but growing graphics products. Commenting specifically on Conwed, the top line in the core quarter benefitted from continued momentum in sediment control and construction related products. These areas were also the best performing products unit per basis. Sales of erosion controlled products grew for the year but were constrained by a fire at one of our customers' plans, which kept the supply chain. We expect these sales to pick back up in 2018 as infrastructure investments and highly development remain robust and the channel debottlenecks next to meet pent up demand. The AMS legacy site closure plan remains on course for phase completion in 2018. Execution of this action should solidify the achievement of our 10 million run rate synergy goal later this year. Regarding segment operating profits, fourth quarter margin were down due to lower organic sales however for the full-year, we saw over 200 basis points of adjusted margin expansion from organic sales growth, favorable mix and the addition of Conwed. For context, AMS segments margins have increased about 400 basis points from the mid-13% level in 2015. 14th Engineered Papers, fourth quarter results were generally as expected though the comparison to last year was challenging. Recall during the fourth quarter of 2016, we delivered particularly high profitability due to a combination of positive factors resulting in elevated margins. That said, fourth quarter 2017 sales were up 2% though the gain is attributable to favorable currency movements, which more than offset a 1% volume decline. Segment volume was driven by lower recon products with a traditional RTL decline partially offset by the Heat-not-Burn ramp up and wrapper and binder volume growth, trends we have seen consistently throughout 2017. Full year 2017 sales were down 2% on a 3% volume decline, which was driven by lower recon volumes as we expected and total cigarette paper volume contracted in line with smoking attrition. These declines were partially offset by non-tobacco volume growth. Lastly, as we've noticed on recent calls, contractually lower LIP royalties have negatively impacted sales and margins throughout 2017. On a separate note, during the fourth quarter, we received the favorable ruling in our LIP patent infringement litigation in Europe. For legal reasons, we cannot provide further detail at this point and we will continue to provide updates as appropriate. Regarding execution of our EP segment priorities, Heat-not-Burn tobacco sales continued to increase during the fourth quarter as the market continues to show positive movement. As we've noted in our earnings call, this product represents a unique opportunity to help offset some of the ongoing headwinds of the tobacco industry; however, it remains in the early stages with much of the global adoption story yet to play out. We'll continue positioning SWM as the supplier of choice for reconstituted tobacco products used in these devices, leveraging our dedicated teams with significant technical expertise, strong relationships across the industry, and available capacity. I will now turn the call over to Allison.

[Allison Aden:]

Thank you, Jeff. I'll now review our financial results starting with AMS segment performance. In the fourth quarter, AMS sales increased 52% to 99 million due to the Conwed acquisition. Organic sales declined 2% due to lower transportation film sales. Adjusted operating margin was 13.4% of sales down 200 basis points. The quarterly margin contraction resulted from soft organic sales. For the full year, sales increased 54% to 433 million driven by the addition of Conwed and 4% organic sales growth. Adjusted operating margin was 17.5% of sales up 230 basis points driven by organic sales growth and the addition of Conwed and related synergies. For the Engineered Paper segment, fourth quarter sales were up 2% despite a 1% volume decline. Favorable currency movements drove the sales increase more than offsetting lower LIP royalties while price and mix were net neutral. Adjusted operating margin was 21.8% in line with the full year margin, but down 480 basis points versus the prior year quarter, due primarily to lower traditional RTL volume, lower LIP pricing in royalties and reduced overhead absorption. Also product costs were unfavorable compared to last year. As Jeff mentioned, the margin decline was managed by a disciplined year-over-year comparison. The fourth quarter of 2016 adjusted margin nearly 27% was the highest quarterly favorite margin in recent years. For the full-year, sales decreased 2% due to the 3% volume decline. Consistent with fourth quarter results, price and mix were net neutral for the year and favorable currency more than offset the decrease royalties. Adjusted operating margin was 22.1% in sales, down 330 basis points. Adjusted corporate unallocated expenses decreased by 7% and 2% for the fourth quarter and follow-up respectively, declining as a percentage of total sales. This decrease is due to lower consulting fees and our continued focus on cost control. On a consolidated basis, fourth quarter sales increased 19%, but were up 1% excluding Conwed and down 2% excluding both Conwed and currency benefits. Fourth quarter adjusted operating profit margin was 12.5% down 310 basis points. For the full-year, sales increased 17% but was flat excluding Conwed and down 1% excluding both Conwed and currency benefits. Full-year adjusted operating profit margin was 16% down a 110 basis points. Shifting to consolidated earnings, we recorded the fourth quarter 2017 GAAP loss of $0.89 per share. The loss was due to the dollar towards a $9 per share of net one-time tax expense resulting from the implementation by the U.S. tax act. Fourth quarter adjusted EPS was $0.64 down from $0.80 in the prior year. For the full-year, GAAP EPS was a $1.12 with the one-time tax expense driving a significant impact. The full-year adjusted EPS of $3.18 exceeded our guidance of $3.15. Now I'd like to provide some context for the recently passed U.S. tax legislation and its impact on SWM. As I mentioned, we incurred a $1.29 per share of net one-time non-cash tax expense in the fourth quarter of 2017. The total incremental net tax imposed by the implementation of the tax act was 48.7 million or $1.59 per share, and was driven by a repatriation tax on undistributed earnings of non-U.S. subsidiaries. The Company will elect to pay this transition tax partially offset by the utilization from credits over eight years as permissible under the new act. The initial annual payment in 2018 is expected to be about $3 million and will offset a portion of the cash benefit to the lower U.S. rate. We also revalued our net differed tax liability as a result of lower predicted tax rates. This resulted in a 9.1 million or 0.30 per share benefit. Excluding the net impact of these one-time tax items, our effective tax rate would have been approximately 26% in the fourth quarter and 30% for the full-year 2017. Currency translation had a $0.05 positive impact on fourth quarter EPS and a positive forcing impact from full-year EPS. In relation to our 2017 guidance, our results were generally in line with our expectations as we outlined at the beginning of the year. The most significant element was the anticipated accretion from the Conwed acquisition which was essentially offset by expected declines in traditional RTL. We had also anticipated higher taxes in certain European jurisdictions. Low LIP royalties and the interest expense impact of an interest rate hedge to fix a proportion of our floating rate debt. These factors played out as anticipated. The most significant headwind we faced in achieving our guidance was the shortfall in the Chinese recon JV, which was expected to deliver additional growth. As we've discussed previous calls, we are tempering our expectations going forward as we work with our JV partners to drive better performance in a challenging supply, demand environment. Now shifting to cash flow and liquidity. 2017 free cash flow was $90 million, about 10% below 2016. While operating cash flow of $131 million was up slightly versus prior year. Total CapEx increased by 10 million to 41 million. About half of this increase was related to the addition of Conwed and the remainder of the increase stemmed from growth projects across the business including the new film line and modifications related to paper line to make specialty filtration products. We also made investments in our AMS manufacturing operations. Moving into an upgraded and expanded facility in China and preparing for a U.S. site closure, both offset which required relocating some equipment. We've previously communicated that 2017 free cash flow was expected to approach the 99 million we generated in 2016. However to ensure consistent customer service during our planned facility move, we build inventories the fourth quarter. Thus we ended the year at higher levels than originally planned. This higher inventory balance drove higher working capital balances impacting free cash flow. Consistent with expected EPS growth in 2018, we anticipate 2018 free cash flow to increase to more than a $100 million. From a leverage perspective for the terms of our credit facility, we were at three times net debt to adjusted EBITDA at the end of 2017, up from two times at year end 2016, driven by the increase in debt at the closing of the Conwed acquisition in January. Absent unusual circumstances or potential acquisitions, we expect to continue to pay down debt in 2018. Now back to Jeff.

[Dr. Jeff Kramer:]

As we look to 2018, our guidance for adjusted EPS is a range from 3.30 to 3.45. The overarching theme is that expected organic sales growth in AMS and further synergy realization are projected to more than offset the tobacco driven headwinds in Engineered Paper. We expect smoking attrition trends in our key markets will be the primary influence on EP results, while anticipated Heat-not-Burn growth offers an offset to traditional RTL declines. This is an exciting inflection point for SWM, as our outlook reflects projected increases in consolidated sales, operating profits, earnings and free cash flow. This growth outlook is the culmination of several years of strategic portfolio rebalancing with AMS reaching the scale necessary to position us for sustainable organic growth. For 2018, we anticipate the reduced effective rate on the U.S. portion of our earnings net of the impact to certain previously available deductions will yield a few 100 basis point reduction in our effective tax rate from the normalized 30% rate in 2017. We caution however that the interpretation and application of this new tax legislation may evolve throughout the year hence potentially impacting our financial results and cash flows. Our strategic priorities remain essentially unchanged with 2018. In AMS, our primary focus areas are to drive accelerated organic sales growth and realized the benefits of our scale platform. The center piece of this optimization plan is the legacy AMS site closure, but we continue to pursue other actions to improve and grow our operations including manufacturing and productivity improvements and segment-wide R&D and product development collaboration. As noted, we will continue to make growth focused capital investments where they advance our strategy such as our first international surface protection film line located in our UK facility and our expanded AMS facility in China. These investments and others to come represents the benefits of AMS increasing scale as we are able to leverage existing overseas assets to help internationalize our business. In Engineered Papers we continue to strategically manage capacity and costs and look to grow share to offset market pressures. As mentioned Heat-not-Burn remains a product development focus and we plan to build upon our strong customer relationships and innovation capabilities to support the potential growth in this innovative product lines. Before wrapping up with closing remarks, I'd like to thank Allison and for our hard work over the past few years, particularly here role in the Argotec and Conwed integrations and leadership of our tax team toward demanding 2017 year-end process. As announced several weeks ago, Allison will be stepping down following a carefully planned transition to our new CFO, Andy Wamser. They are both currently serving as Co-CFOs through March 1st at which point Andy will take over sole responsibility. Andy has an investment banking and corporate finance background mostly in the industrials space and we look forward to his leadership contributions. Andy?

[Andy Wamser:]

Thank you, Jeff. I'm very excited to be joining SWM particular at this point of the Company's transformation and to be partnering with Jeff and the rest of the team to help execute on the business plan. The Company's transformation today demonstrates the commitment to drive value and create sustainable growth, while I've only been at the Company for a short period of time, I've been exceptionally impressed with the team and I'm excited about the prospects for the business and the horizon, most looking forward to partnering with Mark to tell the SWMs story and to developing relationships with our analysts and investors in the months ahead.

[Dr. Jeff Kramer:]

Thanks, Andy. In closing, 2017 was a year of significant developments for SWM. The addition of Conwed to AMS increased our scale and created opportunities to drive optimization synergies across our growth platform, not only with respect to our manufacturing footprint, but also from realigned commercial organizations. Another important milestone is that our total non-tobacco sales reach more than 50% for the first time in the Company's history. Our tobacco operations continue to generate attributive margins and cash flows, but as we look longer term the continued expansion of AMS is critical component of our ongoing transformation into our diversified and growing specialty materials company. Since joining the SWM, I've been assessing our strong global operations, products and end markets and long-term strategy. We believe we've the right strategic direction overall with a strong global franchise underscored by our commitment to delivering highly engineered specialty materials to our customers, fostering collaborative partnerships with them, and focusing on operational excellence. I consider the strategic transformation progress in recent years are significant organizational accomplishment and our view is that Phase I of the transformation is complete. We've rebalanced the portfolio with AMS, now a scale growth platform, which we'll continue to expand through a combination of organic growth investments, and potential acquisitions intended to broaden our end markets, customer base and technologies. We appreciate your continued interest and support. That concludes our remarks. Kim, please open the lines for questions.

[Operator:]

[Operator Instructions] Your first question comes from the line of Dan Jacome from Sidoti & Company. Your line is open.

[Dan Jacome:]

A couple of questions here, I think you said medical is doing very strong in AMS. Can you give us a little color on that? What exactly is driving it? What trends are you seeing? What products, technologies?

[Dr. Jeff Kramer:]

Yes, a lot of our products we are big in wound care and formation of finger bandages, etc., and we continue to have very close collaborative relationships with our end use customers. They continue to grow. There's a new product line coming out called [Sport Stripe] that we're a large component of that is making major gains in the marketplace. So, it's a sum total of a lot of little pieces, it's not one single overarching trend. I think we're just well positioned in that marketplace.

[Dan Jacome:]

What about surface protection? I know a last couple of quarters a lot of nice movement. I think it was in Asia. What you've seen most recently anything to comment on there?

[Dr. Jeff Kramer:]

Yes, I think the underlying trend continued to be the same, as we indicated one of the goals of the AMS division is continued to internationalize our division. We've opened up our expanded supply chains in Asia and that product market is very successful there. You saw we had a little bit of weakness in the fourth quarter and that's really because a lot of that channel was growing very rapidly in the second and third quarters and then they did a little bit of industry -- inventory rebalancing, which is typical for many companies at the end of the fourth quarter. And then we've seen those trends continue. So, we remain positive on that. I don't know if we can see the same double-digit year-on-year growth due to the very strong performance that we had this year, but we are very optimistic about this product line overall.

[Dan Jacome:]

I think in the past you said that surface protection area can grow 5% to 7%. Is that still a reasonable projection?

[Dr. Jeff Kramer:]

Yes I think that's a reasonable projection and there might be a little bit of upside in that. Again, it's an early stage adoption so we're excited about what we're seeing.

[Dan Jacome:]

And then I wanted to ask you about highway constructions just given what the Conwed plastics does, and then I think not an accident in this arena, but there was some changes on the politics side about infrastructure spending I think picking up over the next couple of years under any president. Have you -- do you have any line of sight on that or am I kind of overacting to that?

[Dr. Jeff Kramer:]

Well, you have a much line of sight as we do into our political systems. So I'm not going to try to comment on what people are saying, but we are optimistic on infrastructure. It's clear that the long-term trend in the country is that we need to reinvest in highways and things of that nature. So I'm more optimistic that I think the country is going to realize they need to continue to do that.

[Dan Jacome:]

And then two last small questions. I think you mentioned LIT royalty litigation, there was some change there, but you can't say too much. Any high level views you could supply on the Q&A here?

[Dr. Jeff Kramer:]

No, it's got us litigation, we are really cautious. It's just a comment that we have been depending on our technology or LIP technology is something that we think is very innovative. With one of our large cost customer, we actually have a royalty licensing agreements in and so this reflects another customer, another competitor that we have been just depending on our technology about and had a favorable court appearance that's reasonable.

[Dan Jacome:]

And then last questions, manufacturing improvements, I think you've talked a little bit about that. Can you give us a little bit more details there? What exactly are you going to do?

[Dr. Jeff Kramer:]

Yes, one other thing that we have a strong area of focus on operational excellence in our EP side and that's something that we're now embedding even greater into our AMS side. So, we formed then into a fully integrated operations division. We are optimizing around some of our sights that were closing some and moving other operations and doing that by combining with the best practices, and our Lean Six Sigma activities I think we will be able to continue to drive efficiencies and that's going to be one of our key focuses for the coming years actually.

[Operator:]

Your next question comes from the line of Steven Chercover from Davidson.

[Steven Chercover:]

I wanted to start with AMS and specifically films which performed quite well in 2017, but tailed off in the fourth quarter and you indicated that was an inventory destocking situation, but do you expect the redemption of the low double-digit growth in films in the current year?

[Dr. Jeff Kramer:]

Yes, we are still very optimistic in our film business and we've already seen orders rebound in January to what we are considering more expected level. So, that's why we feel the fourth quarter slowdown is really in inventory adjustments than what we've seen.

[Steven Chercover:]

And then sticking with AMS, the cost of filtration should be fairly easy this year as well, so do you expect the replacement cycle is going to pick up or when might that happened?

[Dr. Jeff Kramer:]

Yes, so we've seen in the last two years a little bit weaker on our RO side, which is the large desalinization plans and our customers continue to tell us that the replacement cycles are starting to come back and that there has been some approvals but new large scale capital particularly in the Middle-East and maybe some over in Asia. So, we're hoping that takes up. Actually, our process filtration which is non-water liquids, if you think about it, it's actually been pretty strong, and then we have a small air filtration business that showed a little weakness but that was primarily due to one customer moving through a different technology. So, we're expecting that business to grow in 2018.

[Steven Chercover:]

It sounds like a couple of major metropolises in both Brazil and South Africa are at crisis levels, so hopefully maybe you can help?

[Dr. Jeff Kramer:]

Well, yes, the problem they face by the way I think that's why we're positive on this, but the long term trends I think continue to favor these types of technology. The problem is, you can't fill them at the last second and that's basically what South Africa is facing is that they had desalinization plants, but they are actually building is not coming online in time, and they're probably going to need more. So, hopefully, we'll see those trends and we're well positioned with the key end use suppliers or so. Hopefully, they'll start seeing their order books increase and that'll flow backward with us.

[Steven Chercover:]

Yes, I mean that's obviously that's big opportunity. Okay, switching gears to tobacco, if I could. Can you tell us how much HnB revenue you guys did in Q4? And is there any reason it shouldn’t see continued growth in 2018?

[Dr. Jeff Kramer:]

Yes, well, what I can share is I think the growth has been faster than we had planned in terms of our operating plan, but with that said I think we continue to caution, it still remains a small part of our RTL, overall RTL business, so it's in the 5% to 10% range right now, so it's just still early enough in this development process that it's really hard for us to forecast how it's going to grow. The key thing I think to say is that we are the innovation partner for choice for anybody who is building Heat-not-Burn technology based on RTL. So, we still remain positive but again I don't -- it's small but fast growing and I think it's going to be something that's going to be attractive for us and help offset some of the pressures we see in our traditional business for years to come. But again I am just a little bit more cautious then others in how I forecast that.

[Steven Chercover:]

Yes, you kind of anticipated my next question which was where are we in the lifecycle of Heat-not-Burn, are we still qualification testing or is it becoming commercial?

[Dr. Jeff Kramer:]

Well, it is commercial, so there're sales around the world but if you think about it from the PMIs and BAPs of the world, they would say this is very early on in their process, I mean they're test marketing in a number of cities, I think they're trying to tweak their formularies to the different tastes around the world, then we're still applying for approvals in various parts of the world. So, I think it's very early in the lifecycle but everything continues to be positive from what I've seen and what I've spoken with our customers about.

[Steven Chercover:]

And then finally just one more big picture question and then I'll get back in the queue, so balance sheet is now three times leveraged and I know that if I am not mistaken 2.5 is the target. Just wondering, if you achieve that perhaps by midyear you're getting close. Do you have acquisition teams that are shaking the bushes to find the next target, or if the right acquisition was equivalence of right now could you pull the trigger?

[Dr. Jeff Kramer:]

Yes, so, just a couple of things, so our -- I just want to emphasize two things, one is our main focus right now is demonstrating the organic growth and getting those synergies that we are -- have promised the investment community this year. So that's our primary focus. Now with that said, we are always looking at what's out there in the marketplace and looking at ways that we can grow our product lines and grow our positions, but it's all around our strategy. So will take hard and looks at that. We've shown that we can handle leverage rates in the 3% to 3.5% so it's not necessarily our goal to get back down to 2% but were going to keep paying down debt and keeping our powder dry and if the right opportunity comes along will look hard at it. I think that's going to be a component of our strategy going forward.

[Operator:]

[Operator Instructions] Your next question comes from the line of Dan Jacome from Sidoti & Company.

[Dan Jacome:]

Just a quick follow-up following on Steve's good question there on the M&A landscape, I was just wondering if you saw an opportunity that was attractive and that hired a nice growth rate on the revenue profile. Will you be willing to look at that for an acquisition even if there was slightly lower say EBITDA margin versus what you've acquired in the past? And I'm just asking because what you've done so far in the last couple of years has been pretty impressive and then consistent to within terms of the growth rates on revenue, and then the high-teens EBITDA margin. Is that still kind of your M&A cookbook or has anything changed?

[Dr. Jeff Kramer:]

Yes, I mean we have a pretty big M&A cookbook in terms of how we look at things. So the first clean-up we always do it strategically does it fit in to what we do today and does it add value to us. So, that's always been to be the first screen. I mean what we do today are not commodity level product, so higher margin tend to come with specialty in niche applications and those are the things we tend to favor. I don’t have though a specific target cut off specifically on the margin returns for the businesses. It's really plays into what we think we could do with them once we get them. And our target is always going to be around that 20% margin as where we want to get things, and so you see right now with AMS, we're moving up across that stream our 17.5% now we've gone up about 300 to 400 points since we done these things. That's going to be that typical model, so the thing I buy and might not have those margins but that would be the expectation that we will be able to move them for a variety from R&D or efficiencies or other synergies.

[Operator:]

[Operator Instructions] There are no further questions at this time. I turn the call back over to the presenters.

[Dr. Jeff Kramer:]

Okay, well, thank you everybody, I appreciate you listening to the SWMs story and we're excited about where we are going and I appreciate you taken the time to join us today.

[Operator:]

Ladies and gentlemen, this concludes today’s conference call. You may now disconnect.